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Ending Financial Repression in China

China has made significant progress since 1978 in opening its
economy to the outside world, but economic liberalization largely
stopped at the gates of the financial sector. Investment funds are
channeled through state-owned banks to state-owned enterprises
(SOEs), there are few investment alternatives, stock markets are
dominated by SOEs, interest rates are set primarily by government
fiat, the capital account is closed, and the exchange rate is
tightly managed.

The consequences of China’s financial repression are easy to
see: a sea of nonperforming loans; misallocation of capital, with
overinvestment in the state sector and underinvestment in the
private sector; politicization of investment decisions and
widespread corruption; poor performance of stock markets even
though economic growth has been robust; an undervalued real
exchange rate; and stop-go monetary policy.

By suppressing two key macroeconomic prices-the interest rate
and the exchange rate-and by failing to privatize financial markets
and allow capital freedom, China’s leaders have given up
flexibility and efficiency to ensure that the Chinese Communist
Party (CCP) retains its grip on power.

Controls on the free convertibility of currencies and on capital
transactions violate private property rights and attenuate both
economic and personal freedom. Indeed, as F. A. Hayek warned in his
classic book The Road to Serfdom (1944):

The extent of the control over all life that economic
control confers is nowhere better illustrated than in the field of
foreign exchanges.

Nothing would at first seem to affect private life less than a
state control of the dealings in foreign exchange, and most people
will regard its introduction with complete indifference. Yet the
experience of most Continental countries has taught thoughtful
people to regard this step as the decisive advance on the path to
totalitarianism and the suppression of individual liberty.
1

Once exchange and capital controls are imposed, they are
difficult to remove. Government officials and special interest
groups will profit at the expense of the public and use the force
of law to plunder rather than protect property rights. That has
been the experience in China and was clearly the case in Europe
after convertibility was suspended in 1931. When convertibility was
restored in 1958, Ludwig Erhard, vice-chancellor and minister for
economic affairs of the German Federal Republic, stated, “Of all
the many possible forms which integration of the free world can
take, free convertibility of currencies is the most fruitful.”
2

Although China has made its currency convertible for
current-account transactions, the capital account is still largely
closed. Moreover, residents are often discriminated against in
favor of foreigners. Making the transition to capital freedom in
China would greatly increase economic and personal freedom and help
bring about political reform. The best way to achieve that goal is
to stick to a policy of engagement rather than succumb to what Alan
Greenspan has called “creeping protectionism.” 3 President Bush
is correct to remind the world, “As the people of China grow in
prosperity, their demands for political freedom will grow as well.”
4

Financial Repression and Its Consequences

In a market-liberal order, in which private property rights are
transparent and effectively enforced, people have the right to
acquire, use, and sell their assets-the prices of which reflect the
capitalized or present values of expected net income streams over
the life of the assets. Those future income streams can be
capitalized precisely because private capital markets exist and
interest rates are competitively determined. In China, most
financial capital is still state owned and interest rates are not
free to fluctuate with demand and supply. Government agencies at
various levels hold majority ownership in joint-stock companies and
many shares are nontradable. Exchange controls limit the ability of
residents to freely convert renminbi (RMB) into foreign currencies,
and capital controls narrowly limit investment options. With few
alternatives, the bulk of household savings is in the form of
low-yielding deposits at state-owned banks, which channel funds to
politically favored investment projects with low returns.
5
Meanwhile, private-sector firms must rely on the informal
market.

Yasheng Huang, an economist at MIT, has shown that China’s
financial market repression is substantial and got worse in the
1990s relative to the 1980s. Using the World Bank’s “World Business
Environment Survey (WBES) 2000” and other indicators, he finds “a
systematic, pervasive, persistent bias in financial policies in
favor of the least efficient firms in the Chinese economy-SOEs-at
the expense of the most efficient firms,” namely, “China’s small,
entrepreneurial and private enterprises.” 6 In response to a survey
question, which assessed the extent of the “general financing
constraint” (GFC) in selected countries as perceived by a sample of
entrepreneurial firms in the nonstate sector in 1999-2000, the WBES
found that 66.3 percent of the Chinese firms considered the GFC a
“major obstacle.” That proportion is the highest among Asian
countries and exceeds the proportion in most transitional
economies, including Russia (Figure 1). 7

While the state sector produces less than one-third of
industrial output value, it receives two-thirds of the commercial
credit flowing through state-owned banks. The lack of transparency
and the politicization of the lending process have led to
considerable waste as seen in the high proportion of nonperforming
loans, estimated at 25 percent or more. 8 Beijing has injected billions
of dollars into the large state-owned banks and is slowly
transforming them into joint-stock companies, but privatization is
taboo.

The People’s Bank of China (PBC) continues to peg the nominal
exchange rate at a disequilibrium level, as indicated by the rapid
accumulation of foreign exchange reserves that now exceed $800
billion. To prevent inflation, the PBC sells securities to drain
off the RMB that are created when the bank buys foreign currencies.
That “sterilization” process, however, becomes more difficult as
the size of China’s current-account surplus grows.

Although China moved to a new exchange rate regime on July 21,
2005, in which the RMB is officially pegged to a basket of
currencies, there has been relatively little movement in the
RMB/dollar exchange rate. After an initial 2.1 percent appreciation
on July 21, the RMB has risen by less than 1 percent against the
dollar. The daily trading band for the RMB/dollar rate remains
fixed at 0.3 percent. However, institutional changes are occurring
to deepen the foreign exchange market and widen the range of choice
for traders.9

China has the most restricted capital markets in Asia. Portfolio
investments are heavily controlled, as are most other
capital-account transactions. Changes are occurring, such as more
lenient treatment of qualified foreign institutional investors, but
at a snail’s pace. 10 A ranking of Asian countries based on the
UBS capital restrictiveness index indicates that China has a long
way to go before it reaches the degree of capital freedom enjoyed
by top-rated Hong Kong. 11

Capital and exchange controls clash with trade liberalization
and are a heavy burden on China’s economy. Of the top 10 global
trading nations, only China has extensive capital controls. In
addition to restricting individual freedom, those controls impose
high administrative costs, distort investment decisions,
misallocate capital, and corrupt what would naturally be mutually
beneficial free-market exchanges. 12

Capital Freedom and Development

Trade liberalization must be accompanied by financial reform if
China is to continue to develop. It makes no sense for a
capital-poor country like China to run persistent current-account
surpluses that lead to net capital outflows-particularly, the
massive accumulation of official foreign exchange reserves used
primarily to purchase U.S. government securities. Ending draconian
capital controls and allowing widespread privatization would
transform China’s socialist capital markets into genuine markets
with real owners who would be responsible for their decisions and
who would steer capital to its highest valued uses-as determined by
free markets, not state planners.

John Greenwood, chief economist at Invesco Asia, Ltd., has
advocated that China abolish capital controls, float the RMB, and
privatize state-owned banks and firms. In his view, “If China’s
capital markets and its industries were normalized (through
deregulation, proper implementation of the rule of law, the
encouragement of private markets, and extensive private ownership),
then China’s balance of payments would no doubt undergo a major
transformation.” 13

The transition to capital freedom will be smoother, says
Greenwood, if the central bank pursues a policy of monetary
stability-that is, provides a framework for long-run price
stability. To do so, however, requires that the PBC let market
demand and supply determine the equilibrium value of the exchange
rate and focus primarily on controlling domestic money and credit
growth, which means interest rates must also be liberalized. On the
other hand, “under a fixed nominal rate framework, external capital
controls are much more likely to be maintained and the adjustments
to the trade and current account are therefore much less likely to
occur.” 14

To those who argue that capital-account liberalization would
destabilize China, just as it did other emerging market countries
during the 1997-98 Asian financial crisis, Greenwood says that the
root cause of that crisis was not capital freedom but rather the
pegged exchange rate system combined with excessive growth of money
and credit beginning as early as 1993. “The general lesson is that
to control money and credit growth within reasonable ranges that
are compatible with low inflation in the longer run, the external
value of the currency must be free to adjust-especially upwards.”
15

If China chooses to keep the RMB/dollar rate undervalued and
maintains capital controls, it will continue to experience stop-go
monetary policy as the domestic money supply responds to the
balance of payments and the PBC attempts to sterilize capital
inflows. This schizophrenic monetary policy-trying to use monetary
policy to manage both the exchange rate and the price level-is
untenable in the long run if China wants to become a world-class
financial center.

The CCP faces a dilemma: it can either maintain the status quo
by suppressing capital freedom to retain its grip on power, or it
can normalize China’s capital markets and risk losing power. If it
chooses the later path, China is likely to become the world’s
largest economy-and possibly one of the freest-in the second half
of this century, and political reform would become a reality.

With stronger private property rights and long-run price
stability, China would attract and retain capital-including human
capital. People would be free to choose in international capital
markets and free to trade. A fully convertible RMB, a flexible
exchange rate, and a stable domestic price level would enhance both
economic and personal freedom.

The Question of Sequencing

There has been much discussion of how China should sequence its
economic reforms and make the transition from financial repression
to capital freedom. It is clear that opening capital markets
without reforming state-owned banks and without maintaining
monetary stability could lead to substantial capital flight and
exacerbate the problem of nonperforming loans. Moreover, there must
be an effective legal system to protect newly acquired private
property rights.

In a recent interview, Zhou Xiaochuan, the head of the PBC,
emphasized that China is committed to create an institutional
framework for a more flexible exchange rate regime “based on market
demand and supply,” and “gradually realize RMB convertibility …
by lifting the restrictions on cross-border capital movements in a
selective and step-by-step manner.” In sequencing the financial
sector reforms, the first priority is to put the banking system on
a sound footing by recapitalizing the large state-owned banks and
turning them into joint-stock companies with the participation of
foreign strategic investors. Further progress must also be achieved
in widening the scope of foreign exchange transactions, including
liberalizing the capital account. Zhou recognizes that
institutional change cannot occur overnight because “people need
some time to learn and adapt to change.” A new “mindset” must be
developed. Moreover, he understands that China “cannot wait to
start reforming the exchange rate regime until all banking reform
measures have been completed.” 16 Reform measures must move
along a broad front.

Financial restructuring is occurring and the new exchange rate
regime should allow for more flexibility, but one should not think
that the CCP will easily give up its control over the financial
sector or allow the exchange rate to be set by market forces.
Political change must accompany economic reform if capital freedom
is to be fully realized.

Policy Recommendations

Economic development-properly understood as “an increase in the
range of effective alternatives open to people” 17 -requires
the protection of both economic and other liberties. Without secure
private property rights and economic freedom, personal freedom will
suffer. Economic liberalization, privatization, and free-market
competition are the only effective means to expand individual
choices and, hence, to develop.

The United States and China need to continue the policy of
engagement and recognize that it is more important to focus on the
issue of capital freedom than on the narrow question of the proper
exchange rate. China should continue to liberalize its exchange
rate regime, open its capital markets, allow full convertibility of
the RMB, liberalize interest rates, and use domestic monetary
policy to achieve long-run price stability. Most important, China
needs to privatize its stock markets, its banks, and its firms.

Many of those recommendations have already been accepted in
principle as long-run policy goals. Indeed, the PBC’s Monetary
Policy Committee, at its third quarterly meeting in 2005,
concluded:

“The market itself should be allowed to play its role in
economic restructuring.”

“Measures should be taken to further improve the managed
floating exchange rate regime and maintain the exchange rate …at an
adaptive and equilibrium level.”

“Efforts should be made to advance financial reform” and “to
enhance the effectiveness of monetary policy transmission.”
18

Those pro-market policy recommendations are a positive sign and
a clear signal that China’s top policymakers are aware of what
needs to be done to improve the financial architecture.

In addition to internal pressures for financial reform, China is
facing external pressures from the U.S. Congress and the World
Trade Organization to end exchange and capital controls. China has
promised to allow full participation by foreigners in its banking
sector by 2007 and to further open to foreign portfolio investment.
However, China is intent on moving at its own pace, especially
regarding the transition to a floating exchange rate regime.
According to Zhou, the “noises” being made on Capitol Hill (e.g.,
by Democratic Sen. Charles Schumer and Republican Sen. Lindsey
Graham) for protectionist measures-if China does not significantly
revalue the RMB/dollar exchange rate-“will not change the basic
conditions and sequence of China’s exchange rate reform.” Such
measures, however, could “disturb the normal course of the reform.”
19

Conclusion

President Hu Jintao’s “big idea” is to create a “harmonious and
prosperous society” via “peaceful development.” To achieve that
goal, however, requires institutional change-namely, a
genuine rule of law that protects persons and property, and a
change in thinking to accept the idea of spontaneous order and the
principle of nonintervention (wu wei).

Long before Adam Smith, Lao Tzu argued that when the ruler takes
“no action,” “the people of themselves become prosperous.”
20
China’s growing middle class and prosperity have come from
increased economic freedom, not from top-down planning. Trade
liberalization and the growth of the nonstate sector have been the
hallmarks of China’s new economy. It is now time to get rid of the
last legacy of central planning-state-directed investment and
capital/exchange controls-and to end financial repression.

Congress would be wise to focus on capital freedom rather than
bash China for its large trade surplus with the United States and
blame that imbalance on an undervalued RMB/dollar exchange rate.
Protectionist measures to force China to revalue would place a
large tax on U.S. consumers and not advance capital freedom.

For its part, China needs to follow the Tao of the market if it
is to fulfill its promise of “peaceful development.” Ending
financial repression by liberalization, privatization, and
competition would increase the chances for political reform. The
United States and other free countries can help China move in the
right direction by adhering to a policy of engagement rather than
reverting to destructive protectionism.

Notes

This article is an expanded version of an article that appeared
in Japan Economic Currents, ( Tokyo, Keizai Koho Center),
no. 59 (November/December 2005).

5 In a study of
China’s financial sector, Genevieve Boyreau-Debray and Shang-Jin
Wei found that funds allocated through the government budget and
through state-owned banks were negatively correlated with the
marginal efficiency of capital. They also found that “the strongest
determinant of capital allocation … appears to be the
prominence of SOEs in local economies.” Genevieve Boyreau-Debray
and Shang-Jin Wei, “Can China Grow Faster? A Diagnosis of the
Fragmentation of Its Domestic Capital Market,” IMF Working Paper
WP/04/76, 2004, pp. 22-23. China’s incremental capital output
ratio, which measures the amount of investment required to generate
an extra dollar’s worth of output, is very high (about 5) relative
to Western market economies, indicating a very inefficient use of
capital. “A Great Big Banking Gamble,” The Economist,
October 29, 2005, p. 71.